Global Economics

Nokia: High Profits in Low-End Phones

The handset maker's third-quarter profit surged 85%, beating analyst estimates and proving there's money to be made on less expensive phones

Maybe there is high profit potential in low-end phones. On Oct. 18, Nokia (NOK) announced that third-quarter profit soared 85%, to $2.2 billion, handily beating analysts' estimates and sending its stock surging.

The strong showing is something of a surprise, not only because it comes just as telecom equipment makers Ericsson (ERIC) and Alcatel-Lucent (ALU) are struggling, but also because Nokia is the first mobile-phone company to show it can make healthy operating margins on entry-level phones. "The profitability is stunning considering the sales in the low end of the market," says Richard Windsor, a financial analyst who tracks Nokia for Nomura Securities (NMR).

Nokia reported that third-quarter revenues rose 28%, to €12.9 billion, or $18.3 billion. Net income increased to €1.6 billion, or $2.2 billion, which works out to 40 eurocents, 6 cents more than analysts had been predicting. The report came just two days after Ericsson reported third-quarter earnings that fell far short of expectations (BusinessWeek.com, 10/16/07), wiping out some $17.5 billion in market capitalization.

Helping Nokia is the continuing strong demand for mobile phones. The company shipped 112 million units for the quarter, a record for the industry. Nokia now predicts that 1.1 billion mobile devices will be sold this year, up from 978 million in 2006. The company's results follow strong profit reports from mobile-phone rivals LG, Samsung, and Sony Ericsson in the third quarter. Michael Walkley, a wireless technology analyst at Piper Jaffray (PJC), says the fact that so many of the handset makers are doing well underscores the robust demand for mobile phones, even in a relatively benign pricing environment. Motorola (MOT), another top rival, is slated to report results on Oct. 25.

Healthy Margins

But Nokia is the only manufacturer that's managing to do well even as it pushes aggressively into the low end of the market. The company impressed financial analysts by reporting healthy operating margins, despite a sharp drop in the average selling price of its phones. The average price dropped to €82, or $116, in the third quarter, from €90, or $127, in the previous quarter. Nevertheless, the company's operating margins in its mobile-phone business increased to 22.6% in the third quarter, up from 21.2% in the second quarter. The decrease in average selling price was the result of a sharp uptick in the number of phones it sells for less than €30, or $42.54.

With the widest range of phones of any handset maker, Nokia is managing to do well in low-end phones, top-of-the-line, and pretty much everything in between. "We can make money on a €300 phone, a €150 phone, or a €30 phone, and nobody else has been able to do that last part," says Rick Simonson, Nokia's chief financial officer in an interview. "Even when we are selling a €30 device, we are making gross margins in the high 20% range," he says.

Nokia now holds 39% of the mobile-phone market globally, more than all three of its closest rivals—Samsung, Motorola, and Sony Ericsson—combined. The company predicts it will be able to match that market share in the fourth quarter, which would boost its share for the year from last year.

"We have been able with our volumes and marketing money to make it very difficult for competitors to match what we can offer," says Simonson. "And in the markets where we are also selling other products with heavy advertising behind the Nokia brand, there is a big overflow of marketing money in the sub-€30 segment."

Low-End Bonanza

Take India, one of the most promising and lucrative new markets for handset makers. The Finnish phonemaker's brand is now "what Kleenex is to tissue," says Piper Jaffray's Walker. Over 50% of all of the handsets sold by Nokia in the country are under €50, or $70.91. Sales of phones for less than €30 are growing fast and are expected to represent as much as 20% of the total device market in 2007.

While rivals are leery of following Nokia into the low end, the company has plenty of competition elsewhere. During an Oct. 18 conference call with investors, Chief Executive Olli-Pekka Kallasvuo singled out Apple (AAPL) and Research In Motion (RIMM) as competitors he's keeping an eye on.

Nokia holds 50% of the world market for smartphones, the pricey devices that let people handle e-mail, Web surfing, and more. But competition is expected to intensify as RIM continues to introduce devices and Apple's iPhone goes on sale in Britain, France, and Germany. "We are investing more money so that we can not only match that competition, but beat that competition," says Kallasvuo.

Allaying Some Worries

The U.S. is one of the company's few weak spots. Its market share is well behind what it holds overall in the world, in part because of technology issues and also because powerful wireless operators such as AT&T (T) and Verizon Communications (VZ) have chosen to use more malleable handset suppliers. Kallasvuo acknowledges the challenges, but says Nokia is determined to improve its overall position in the North American market. "We are not home and dry," he says. Next year "will be a critical year."

Kallasvuo also tried to allay a few fears about the company's future. In particular, he addressed concerns that Nokia's push into services could damage its relationship with wireless operators, by putting the company into competition with its own customers. On Oct. 1 the company made its biggest acquisition ever, agreeing to spend $8.1 billion on Navteq (NVT) (BusinessWeek.com, 10/1/07), a Chicago company that provides the digital mapping information underlying navigation devices and Internet services. Nokia already offers its own music service, similar to what companies such as Verizon offer.

In the third-quarter conference call, Kallasvuo pointed to an Oct. 9 deal with Spain's Telefónica as an example of the opportunities ahead. The two said they will work together to accelerate the adoption of new Internet services on mobile devices by giving Telefónica customers easy access to Net services developed by both companies. "We have ongoing discussions with many other operators across the world, and you will hear much more about that going forward," says Kallasvuo. "We can bring a lot to the table when it comes to services."

Who says Nokia can't find opportunities to cooperate where others see only competition? Its success in low-end phones shows the Finnish phone giant is able to pull off what few others can.